The Ethics of Ethics Programs

In response to society’s demand for a stronger emphasis on business ethics, in light of recent publicity concerning unethical business practices, and in trying to be in compliance with new federal and state regulatory laws, many businesses have created or strengthened ethics programs. These programs are most effective when they flow out of a culture that values practicing business legally and ethically. However, there are a number of ethical issues which are themselves raised by ethics programs that demand more visibility and thought if these programs are to be ultimately most effective.

This article is based upon the author’s in-depth study of what appears to be a very fine ethics program at a major Fortune 500 company. As part of this research, the author was given unprecedented access to directors of the program, investigators, and even, on the one hand, whistleblowers, and on the other, targets of investigations. The article will focus on two concerns: 1) ethical issues raised by whistleblowing, and 2) addressing the ethical issues when an individual has become the target of an ethics investigation. The purpose in each case is to raise consciousness and to stimulate thought and further discussion; opinions may be expressed to stimulate thought, but are not intended to be prescriptive.

How ironic that ethics programs themselves raise unique ethical questions! But ignoring these ethical issues can only lead to undermining the good that ethics programs are designed to do.

The Ethics of Whistleblowing

Most serious ethics programs have some system by which employees may notify an ethics administrator or other corporate official of alleged impropriety. Usually, this notification is by email or telephone hotline with, at a minimum, the promise of confidentiality and often the possibility or assurance of anonymity. But the mere existence of a hotline raises numerous concerns.

Concern #1 – Being a Fink

An immediate problem in an organization is that any system of whistleblowing goes against the strongly held American value of not being a “fink.” From an early age children learn the dire consequences of being called a “tattletale.” The question arises, how can we get people to blow the whistle on someone when they should?

The answer, undoubtedly, is education. Employees need to be educated to realize that ethics violators hurt everyone and in extreme cases could even threaten the financial viability of the company. Employees also need to understand that under certain circumstances, blowing the whistle may be the right thing to do, and not doing so would be wrong because it could lead to injury to the group. To help educate, it might be useful to explore why employees are reluctant to inform on wrongdoers.

Is it because they fear social ostracism?

Do they value uninvolvement over involvement because they are lazy or indifferent?

Is there a loyalty issue? To whom?

In ethics training, discussing feelings could help employees see more clearly some reasons why in some circumstances whistleblowing can be the right action. Encouraging employees to explore under what conditions they would believe it is morally right to blow the whistle in the abstract could lead to a more informed group of employees who could act responsibly in their use of a hotline in the appropriate case.

Another approach to supplement this type of education would be to educate employees to use the hotline to seek advice. Programs that have been in existence for several years, over time almost always see the number of calls on the hotline go from approximately two-thirds being allegations of wrongdoing to two-thirds being advice-seeking as employees realize they can use the hotline as a resource. As employees seek advice regarding the legitimacy of their own behavior and that of others, one can be assured that the ethics program of the company is maturing.[1]

Concern #2 – Confidentiality

Hotlines are not viable unless confidentiality is perceived to be assured, yet is it really possible to make such assurances because of the inherent difficulty of doing so? Some companies simply say that they will do their best to preserve confidentiality and inform the whistleblower that a court could force them to reveal the whistleblower’s identity. Having so informed the informant the company feels morally (and legally) free to reveal its source if legally required to do so.

Additionally, given the nature of the investigation that will undoubtedly be conducted, will it be possible to keep hidden the identity of the informer? Questions also arise concerning records. Where are they kept? Who has access to them and under what conditions? Records raise difficult issues because they would also pertain to the object of an investigation. Protecting an innocent person would appear as important as protecting the identity of a whistleblower.

Concern #3 – Protection from Reprisals.

Is it really possible to protect the whistleblower from reprisals? The “2011 National Business Ethics Survey” of the Ethics Resource Center indicates that retaliation against whistleblowers is actually on the rise.[2] In a formal sense it is probably possible to guard against reprisals by monitoring pay increases, promotions, organizational climate surveys, and complaints related to the whistleblower. Yet, one might well suspect that such action would be ex post facto at best—not preventative. The far more difficult problem is preventing and dealing with informal reprisals such as social ostracism, looks, and comments. Here again, the problem is that no one likes a “fink”; the only viable approach is education, and in this area it is likely to be an imperfect solution at best. Strong and decisive action against those who inflict reprisals may also help.

Concern #4 – Frivolous Complaints

There is always the possibility of frivolous or malicious complaints, which may be designed to pervert the purpose of the company’s investigatory process. Is there any protection from such complaints? The best protection may come from quickly finding that there is no case and formally closing the investigation. To fail to investigate an allegation just because someone believes it to be unfounded could very well undermine confidence in an ethics program. Perhaps the recipient of the call could attempt to educate the caller if there is a suspicion about the validity of the allegation; to inform the person’s management (if the caller identifies himself or herself) would constitute a reprisal.

Yet there is a problem in that an ethics program can be seen as giving dangerous power to malcontents and encouraging reckless participation. In a way the caller gets rewarded by the fact that the system pays attention. To counter this problem, most companies have a rule which prohibits employees from making false and malicious statements about other employees. Still, the hotline might constitute an exception to the rule in order to make sure employees are forthcoming. One might argue that a first offense should be exempt from any repercussions, but not a second one, if the hotline has been contacted.

Concern #5 – Motive

Is the motive of the whistleblower pertinent? Frequently that which is reported on the hotline has been going on for some time, but there is a trigger that causes the person to report it now. A common trigger is a recent adverse management decision affecting the complaining employee. Still, experience has demonstrated that the motive of the informer is not that pertinent or cannot be considered so if there is to be a very creditable ethics program. Besides, motives are rarely singularly pure, but rather mixed. The focus should be on the validity of the allegation—not the motives of the one making the allegation – in order to cast the widest possible net.

Concern #6 – Revealing the Outcome

Should the whistleblower know the result of the investigation? Most programs allow the caller to check back and hear the result in a general way. For example, the caller might be told either, “We investigated and found a violation and an appropriate sanction has been given,” or “We investigated and did not find any violation and thus the case has been closed.” If the caller requested confidentiality and also requested knowledge of the results, he or she might be given a case number to check on. One might well question the ethics of getting too specific with the details of any sanction. The main point should be that action was taken if it was warranted. Research shows that regular communication with employees about a company’s responsiveness makes it more likely that misconduct will be reported.[3]

The Target of the Ethics Investigation

Four major questions arise regarding the object of an investigation.

1. First, is it possible to reliably assume and maintain the innocence of the target until the investigation is complete?

There appears to be something that causes people who conduct the investigation to believe, or at least communicate the feeling, that the object is guilty until proven innocent. Perhaps, it is the very word, “ethics,” that causes this condition. Most targets will tell you they felt that investigators were questioning their innocence, not their guilt; in other words, investigators assume guilt, not innocence. Targets wonder why such instant and high credibility is given to the whistleblower simply because an allegation has been made.

One can argue that managers, as opposed to non-managers, who are targets must accept such assumptions as a part of the territory of being in management. Managers might not agree, but even if they did, what about non-management targets? Did they give up their right to be presumed innocent until proven guilty when they accepted employment? One would doubt this to be the case. The presumption of guilt goes against the grain of a supposedly strongly held American value (innocent until proven guilty). Training programs should help investigators maintain an open mind until their work is completed, as experience has shown this is difficult to do. Furthermore, good management theory would suggest that targets should be treated with respect, dignity, and support until a case is clearly proven against them.

2. At what point in an investigation should the target be notified that he or she is indeed a target of an ethics investigation?

Most targets appear to want to know right away, but some investigators argue that it is best to discreetly check on the facts to verify whether or not a full scale investigation is necessary. If the facts do not check out, the case is closed and the target has never been disturbed. In such cases is it in a person’s best interest not to know, or does the company even have the moral right to decide in such matters what is in a person’s best interests? Targets often point out that they could have cleared matters up quickly had they known there was an allegation against them. How does the above approach square with the normative right that one should be able to face his or her accuser or at the very least to hear the accusation? Of course, facing one’s accuser or perhaps even knowing the allegation itself could jeopardize the promised confidentiality. Here we have a clash of two powerful values.

More questions can be raised. Can a company be held legally liable for not informing a target that he or she is a target? At what point does it become legally and/or morally compelling to do so? If the company investigator brings the company attorney to interview the target, can the results of an interview be used in court? Is it morally right to use information no matter what means were used? Few would maintain that any means were justified by the end. Do such things as constitutional and due process rights have a place here? Most would think so. Raising these types of questions suggests the scope and magnitude of relevant questions in this area. To be sure, most of these questions are not easily answered, but they need discussion.

3. At what point, if any, should an employee’s management be notified of an ethics investigation?

Some are concerned that if management is notified quite early in an investigation that management will have the opportunity to cover up any involvement that it may have with the allegation. Frequently, management itself may have contributed to an unethical action, perhaps even by the climate and tone that are set. Each case might be different, but it would appear that management should be notified only when it is clear that they are not likely to have been connected with the alleged ethics violations. Certainly, management should be brought in toward the conclusion of the case and be involved in any disciplinary action.

4. What is the impact on work and employees’ morale as a result of one of their own being investigated?

There have been instances where employees became very upset with a company when one of their trusted managers, peers, or subordinates was the object of an investigation that they thought was not justified. This is especially true when they believe that a disgruntled, unproductive person made an unjust allegation and the company responds to the complaint of such a person, thereby putting an innocent person through mental anguish. Resentment toward the company can run deep in such situations. Yet, one can raise the question, what if warranted complaints are not investigated because too many barriers are raised? Would not employees resent that as well? How can an ethics administrator know what is a valid complaint and what is not? The integrity of the ethics program would seem to demand investigations of all complaints. Probably a part of the solution to this problem resides in improving the quality of the investigatory process. Thus, again both education of the company as a whole, and specific training of the investigators, appear vital.

Conclusion

The fact that ethics programs have their own interesting set of ethical questions demonstrates the dichotomies that are raised when a company’s culture is challenged. Examining just two of the areas amply illustrates this irony and the depth of the issues created. Businesses are to be commended for having taking the courageous and costly step of establishing substantive ethics programs. The next step, however, is to examine carefully the kinds of issues that have been identified above and take appropriate measures to ensure that ethics programs themselves are as concerned about their own ethics as well as of those they seek to influence. Knowing what these appropriate measures are will only come as a result of meaningful dialogue. Many companies do periodic audits of their ethics programs. Addressing the questions raised herein and attempting to answer them as a part of that audit would strengthen these programs and ultimately contribute to a culture that encourages ethical behavior, which is what makes ethics programs most effective.[4]

“Spiritual Capital and Virtuous Business Leadership” with Yale’s Ted Malloch

Theodore Roosevelt Malloch, PhD, is Chairman and CEO of The Roosevelt Group, a leading strategy thought leadership company, through which he conceptualizes and executes some of today’s most dynamic international projects. Dr. Malloch has held an ambassadorial-level position at the United Nations, as well as senior policy positions at the U.S. Senate Committee on Foreign Relations and the U.S. Department of State.

Theodore Roosevelt Malloch, PhD

He is a research professor at Yale University, where he founded the Spiritual Capital Initiative and produced the documentary, Doing Virtuous Business. The film explores the concept of “values-based” management strategies that can both improve the bottom line and strengthen a company’s relationships with customers, employees, vendors, the environment, and the world at large.

Malloch’s many books include: Trade and Development Policy; Beyond Reductionism, Unleashing the Power of Perpetual Learning; The Global Century, with Scott Massey; Renewing American Culture: The Pursuit of Happiness; Being Generous; Thrift: Rebirth of a Forgotten Virtue, and the classic best-selling Spiritual Enterprise: Doing Virtuous Business.

In this video, Malloch visits with Samuel L. Seaman, PhD, a professor of decision sciences in the Graziadio School of Business and Management. They discuss the following questions:

What is spiritual capital? How does it change businesses for the better?

Is it possible for companies to satisfy their obligations to shareholders and still conduct business by virtuous means?

Are there special considerations that a management team should make if they want to truly incorporate a virtuous business model for a publicly traded company?

We seem to keep falling into the same traps and the media has made much of the lack of morality in business. Is the notion of virtue lost on contemporary society?

Is virtuous business a fad? If not, what is the essence of its staying power?

Do you see a role for altruism in business, where there is no expected payback?

What are some narratives that are helpful in trying to identify business virtues and instill them in others?

The Make Money on Foreclosures Answer Book by Denise L. Evans

The Make Money on Foreclosures Answer Book

Author Denise L. Evans, an attorney, is an expert in foreclosure law and she provides easy-to-follow questions and clear answers to questions about foreclosure, such as “What is a foreclosure?” and “Should I rent to the former owner?” The book covers nearly every question I could pose regarding foreclosure, and they are easily and clearly answered.

The book’s 10 comprehensive and easy-to-read chapters include Foreclosure Basics, Understanding the Parties and Their Motivations, Bankruptcy and Foreclosure, What You Should Know about Taxes, and The Former Owner. The five appendices provide a business plan, excellent state-specific information, real estate contracts information, and spreadsheets that provide models readers can use.

This is a superb book for readers interested in the subject of real estate, particularly if they are interested in foreclosures.

More Than Money

Mark Albion spent nearly 20 years as a student and professor at Harvard University and its Business School. A seven-time social entrepreneur, he left Harvard to develop a community of service-minded MBAs, co-founding Net Impact in 1993. He has made over 600 visits to speak at business schools, covering over 135 different schools on five continents, for which Business Week dubbed him “the savior of B-school souls.”

Note: If the file does not download automatically, right click on the download icon and click “Save Target As…”

Questions for Dr. Albion:

The common theme throughout your books is in a sense, the name of your latest book—it’s about “more than money.” As someone who has spent their life in the world of business, how have you reconciled the two?

Tell us more about Net Impact, and how you use “business to improve the world.”

You are also very involved in the Social Venture Network, which is committed to “building a just and sustainable world through business.” How do the two groups differ? Essentially, why would a social entrepreneur get involved with one over the other?

What can business managers, owners, entrepreneurs, do to incorporate a values-based approach to their work? What are the questions they need to ask themselves? The actions they need to take?

Much has been said about Generation Y and their community-mindedness. In the 15 years since you founded Net Impact, have you seen a generational shift towards giving back?

The other thing you hear about Generation Y is how much they like to switch jobs. As these new graduates enter the workforce, how can organizations use service and community incentives to help retain them as longer-term employees?

Just Good Business by Kellie McElhaney

While everyone from corporate board members to Sports Illustrated writers[1] is discussing global warming and going green, Kellie McElhaney’s timely book Just Good Business: The Strategic Guide to Aligning Corporate Responsibility and Brand discusses the ethical business strategy called Corporate Social Responsibility (CSR).

Although CSR is known by a dozen different labels, McElhaney defines CSR as “a business strategy that is integrated with core business objectives and core competencies of the firm and from the outset is designed to create business value and positive social change, and is embedded in day-to-day business culture and operations.” CSR is useful for attracting certain market segments, building market share, and if done right reducing bad press from watchdog groups and protesters.

Part I of Just Good Business introduces CSR while Part III explains what to do about it. Part II discusses the seven principles for connecting a corporation’s CSR strategy to its brand:

Know thyself.

Get a good fit.

Be consistent.

Simplify.

Work from the inside out.

Know your customer.

Tell your story.

Each principle has its own chapter offering good corporate examples that flow nicely with the text. Because the author has kept these stories short, at less than a page, they make the point without distracting the reader. The book concludes with chapters on planning, smart metrics, and the future of CSR.

This is a medium-sized, 194-page, and very readable book. McElhaney brings more than just the CSR story to the reader; she provides an action plan tied to corporate branding and marketing. I recommend this book to those who want a role in the future of their corporation’s CSR strategy.

Soul-ed Out

In his bestselling first edition, author Kevin Cashman tapped into the duality of mankind and compelled his readers to be authentic. He challenged us to venture deep inside ourselves and consider our values, essence, and purpose. Spiritually reminiscent of The Pilgrim’s Progress, Cashman described our journey and the challenges along the seven pathways to leadership mastery, while encouraging the reader to be reflective and transcendent. The essence of the first edition is best captured in the following quote from the text:

Leadership from the Inside Out is about playing the song of our life with depth, grace, and passion.

Cashman’s thesis was and is particularly relevant in the current climate of leadership failures and vilification of leaders who stumble on their journeys. A values-centered, ethical leader (or emerging leader) will find his premise compelling and his reflections illuminating.

After a decade of success and the corporate acquisition of his first edition, Cashman has published this second edition, in which the seven pathways to mastery personal, purpose, interpersonal, change, resilience (formerly balance), being, and action are now steps, and the author provides more “tools.” Indeed, the second edition is less reflective and formatted more like a workbook than the first edition.
The seminal quote from this revised, commercialized second edition?

Leadership from the Inside Out is about playing the song of our life with depth, passion, and world-class skill. [emphasis added]

While reminding us to lead by who we really are, the second edition seems to have lost some of the soul and expression that made the first one so rich it feels pasteurized and homogenized, as though written by corporate committee, not by an inspired heart. Ironically, while Cashman compels us to “transcend what is” as leaders, his second-edition revisions seem to reflect the results of surveys and “what we have learned in the marketplace,” (i.e., what is); and thus, he tragically falls on his own commercialized, deductive sword.

Creating a World without Poverty: Social Business and the Future of Capitalism By Muhammad Yunus

Creating A World Without Poverty details the compelling, personal journey of author Dr. Muhammad Yunus of Bangladesh. Yunus, a former economics professor, received the Nobel Peace Prize along with the Grameen Bank, which he founded, in 2006. He has developed a concept called, “social business,” the goal of which is the operation of self-sustained businesses owned by and of service to the poor.

A social business pays no dividends; it sells products at self-sustaining prices and the profits are used for expansion into new products, services, or members, so that the business furthers its service to the poor. Social businesses are owned by the people they set out to help, giving them a direct stake in improving their own lives and communities.

Yunus first explains why traditional sources of funds for world poverty, such as the World Bank and the International Monetary Fund, have limited abilities to help the poor, and offers suggestions on how to make these organizations more effective. He also explains why other economic models fail to reach the poor.

For example, while the very popular corporate social responsibility (CSR) movement focuses on the triple bottom line of profits, people, and planet (learn more here), after a while, profit always emerges as the main focus. If a company devotes a penny to CSR, it then uses 99 cents to make society worse, Yunus writes. He also discusses the flaws of socially involved, profit-maximizing businesses, co-ops or cooperative businesses, non-profits, and charities.

Yunus then explains how the Grameen Bank (Grameen means “village” in Bangla) got started and spawned many other social businesses. Grameen Bank makes micro loans to the poor at reasonable costs (as low as $15) without the need for collateral. Grameen started a grassroots movement that empowered families to become self-sufficient and to contribute to society. So far, loans have aided in the construction of over 650,000 houses that would not have qualified at regular banks. Since 1983, Grameen has granted micro loans worth six billion dollars to over seven million people. The repayment rate has been an astounding 98.6 percent.

Yunus spends the rest of the book defining what a social business is and what it is not. Capitalism is a half-formed, one-dimensional idea in need of the multi-dimensional goal fulfilled by social businesses, according to Yunus. He lays out a plan for any country or community to develop their own social businesses. “If we are not achieving something, it is because we haven’t put our minds to it,” he writes.

Necessity and creativity keep the concept of social businesses growing and changing. From small loans to women for buying cell phones and selling talk time came loans for houses, health care, and a micro-factory to produce yogurt for the poor, supported by surrounding micro-farms. This last initiative was a hybrid effort with Danone, the first multinational social business, and it provides a model for how for-profit businesses can devote a portion of their resources to a social business.

Even though there are 30 MBA programs in social entrepreneurship in the United States, there are no programs for social businesses. For a good, quick review of the book’s highlights, read Yunus’ Nobel Prize acceptance speech at the end. I highly recommend Creating a World Without Poverty for anyone interested in helping this world become a better place through business.

The Breakthrough Company by Keith R. McFarland

The Breakthrough Company is an astute analysis of what makes the difference between companies that become stars and the “also-rans” we never hear about.

Author Keith McFarland does not take a “flavor of the month” approach to leadership. The book, which is already ranked as a top business best seller by The Wall Street Journal, is based on a five-year study of some 7,000 growth companies. I appreciated the well-chosen and insightful vignettes, such as the one in which the author compared two companies with very similar beginnings-one became an exceptional performer and the other just barely survived. You might wonder how two companies in the same business located just a few hours apart could have such different performance records. From his face-to-face interviews and careful analysis, McFarland teases out the critical factors. Another example worth the price of the book is the story of how the executives at Intuit bested Microsoft in the small business accounting market.

The Breakthrough Company does not claim to be about leadership or ethics, but it is. The chapter on Building Company Character caused me to rethink my understanding of corporate culture. McFarland writes that the one characteristic common to all the breakthrough CEOs studied was charisma: “Charismatic leaders inspire us with their character.” His discussion of the roots of the word “charisma” is inspiring! Drawing on the writings of the early 20th Century sociologist Max Weber, he defines charisma as “a devotion to the exceptional sanctity, heroism, or exemplary character of an individual person.” Then McFarland writes “Character is sacred… Character cannot be faked.” It was at this point, half-way through the book, I decided to make it a required reading for all of my MBA students.

McFarland, a one-time Associate Dean at the Graziadio School of Business and Management of Pepperdine University, had a reputation for easily establishing rapport and trust; in The Breakthrough Company he accomplishes just that. While every page conveys important information, the tone is like a candid conversation over a cup of coffee.

A very full index and extensive reference notes will satisfy the academic reader. That McFarland conveniently provides a summary of key ideas at the end of chapters will be a great help to my students! I am recommending this book to my executive clients and friends.

The Moral and Financial Conflict of Socially Responsible Investing

Who is responsible for corporations making socially responsible choices? Is it the CEO, the public, the government, or the investors? If an investor follows his conscience to invest in socially responsible companies, will he lose money, or does socially responsible investing pay off in the end? This article addresses these questions.

Photo: Mikhail Tolstoy

One of the most important tasks of a modern industrial society is the allocation of capital. It is absolutely essential that in a democratic milieu capital assets be allocated to benefit the majority of productive individuals. William J. Baumol, a leading political economist of the 1960s, has noted the following:

The allocation of its capital resources is among the most important decisions which must be made by an economy. In the long-run an appropriate allocation of real capital is absolutely indispensable to the implementation of consumer sovereignty (or of the more appropriate concept—public sovereignty—which takes into account all of the relevant desires of the individuals who constitute the economy).[1]

This article addresses the central question of public sovereignty of the capital markets wherein the public, and not bankers, decide the allocation. Is the current methodology of capital allocation taking into account all of the relevant desires of the public who constitute the economy? The debate centers on socially responsible investing (SRI). What is more important, morality or profitability, and are they mutually exclusive? Do corporations have a responsibility to the environment, to their employees, to the communities in which they reside that supersede the corporations’ responsibilities to investors? On the other hand, do investors have the responsibility of focusing on companies that have great socially responsible track records over corporations that fail on these records while seeking dividends and price appreciation?

While capitalistic markets are disproportionately focused on “profit at all cost,” few trends would so thoroughly “…undermine the very foundations of our free society as the acceptance by corporate officials of a social responsibility other than to make as much money for their stockholders as they possibly can,” said the late Milton Friedman.[2] Likewise the late George J. Stigler noted the importance of capital markets’ regulation of behavior.[3] Both of these economists are Noble Prize recipients as well as coming from the Chicago School of Economic Thought giving even more substance to their comments. This latter comment remains as important today as when Stigler made the statement. Secretary of the Treasury Paulson on November 20, 2006 called for the U.S. to “rethink” governance rules to keep the U.S. capital markets competitive.

If we believe that American public sovereignty of the capital markets include ethical behavior with equal financial results, it is obvious that we are in serious denial with some radical change in business behavior required. Otherwise, we end up just like any other third world country.

Shareholder Wealth

More often than not, corporations today are expected to utilize the shareholder wealth model, developed in the 1950s, stated in terms of maximizing shareholder wealth. In general, such a model demands a large earnings per share (EPS) growth rate without any social considerations. Historically, this has not been the case. Corporations were at one time essentially privately owned as well as local in character. Consumers more or less assumed that the entrepreneur’s own morality was incorporated into the firm. If a corporation behaved poorly by a community’s standards, this firm often would be boycotted especially if a substitutable product or service existed. We still see a modest amount of boycotting, but it is almost solely confined to small businesses with consumer sales. It is perhaps unfortunate that one cannot invest in many of these small businesses and their potentially higher community standards.

This provincial approach all but disappeared with the rise of the modern public corporation by the 1920s. This divorce of ownership from control resulted in a new form of economic behavior as so clearly noted by Berle and Means in 1932.[4] In the opinion of many, one aspect today of this separation of ownership from control is excessive pay to executives, predominately through stock options, which encourages dominance of the EPS growth aspect at all costs. This obsession with wealth has further caused a major ethical issue of backdating of options, which appears to have become widespread among American corporations. The theft of stockholders’ funds in recent times appears to run into billions of dollars.

The magnitude of the ethical problem for American corporations can be noted by the statement from Transparency International (TI), the anti-corruption watchdog, While TI concentrates predominately on international business transactions and the corruption of governments, it is not solely derived from this perspective. Thus, on Monday, November 6, 2006, TI reported that “the U.S. has suffered a ‘significant worsening’ in the perceived levels of corruption.”[5] The U.S. fell from a ranking of the 17th least corrupt nation to 20th among the 163 nations reviewed by the Berlin-based organization with a score of 7.3. This score equaled those of Chile and Belgium. Indeed, it should be noted that both Singapore and Hong Kong are ahead of the U.S. on this critical issue. One concluding comment from The Financial Times stated that “For companies, thinking just in terms of compliance is not enough.”[6]

When corporations make heinous decisions in an attempt to attain a high EPS growth rate (such as Ford’s decision to produce the Pinto in the face of overwhelming evidence that the vehicle was unsafe), the government steps in to administer punishment. Such decisions become more opaque, however, when the ethical/moral issues are less explicit and difficult to quantify. A case in point is the mining industry. Although mining is necessary to gather production resources for a modern industrial economy, it also often damages the environment. Is it wrong to prospect for sources at the expense of the natural environment?

Through their demand for equity, investors can dictate what is most valued in world opinion. For example, if companies whose pollutants damage the environment see their stock prices plummet, the cost to such companies of converting to a more environmentally conscious operation would no doubt be offset by positive price appreciation in their stock accompanied by a reduction in their cost of capital.

Socially Responsible Investing (SRI)

In a capitalistic marketplace, the stockholders hold the “ultimate authority” over corporate conduct. Unfortunately, it is a “passive” ultimate authority. Due to the U.S. Securities and Exchange Commission’s unwavering support of corporate management in proxy matters (in the opinion of the authors), the only “ultimate authority” is the passive strategy of selling the underlying interest rather than trying to change the behavior of management. Another, more pro-active strategy would be to limit investments to companies meeting reasonable criteria for the concept of a Socially Responsible Investment (SRI). Yet another, even more pro-active strategy, is to have the SEC or Congress change the proxy rules. This may happen due to recent Federal court decisions questioning the SEC’s position on shareholders’ proxy rights and the difficulty of placing issues before shareholders at the annual meeting.

Socially responsible investments “to a large degree depends on the investor.”[7] While some estimate that the market for socially responsible investment (SRI) funds stands at $2.16 trillion,[8] the actual criteria used to define SRI are rather subjective. The Social Investment Forum lists 12 types of screens for company exclusion. These screens include the following industries or issues: alcohol, tobacco, gambling, defense/weapons, animal testing, product/service quality, environment, human rights, labor relations, employment equality, community investment, and community relations. Many believe that other screens need to be added such as ethical management. Needless to say, there will be no end to the debate dealing with the proper selection of screens for SRI.

Value Based Leadership (VBL)

Many individuals can reasonably disagree over some of these screens. Many individuals also believe that other screens need to be added. One of the most commonly suggested is Value Based Leadership (VBL). For example, companies found engaging in unlawful or immoral conduct, such as backdating options, should be rejected as an investment candidate until the guilty company is rehabilitated. In fact, the potential screening list can almost reach the point at which all companies must be eliminated. Hence, there is a real need to develop a consensus regarding the VBL definition. In fact, there is a real need for a consensus selection of companies that would become part of an SRI Index. Investment managers today basically develop their SRI qualified companies through internal analysis.

Finally, there is the problem of selective screening. Certain mutual funds also select companies based on other criteria. For example, the Aquinas SRI mutual funds invest in only those companies that reflect core Catholic religious values, while the Sierra Club mutual funds invest in only those firms that have positive environmental track records.

The securities markets are comprised of companies having vastly different moral and ethical track records. The concept being suggested here is the recognition of the Value Based Investor (VBI). If Value Based Investors exercised their financial power by encouraging social responsibility among corporations, then a large sum of investment dollars would flow from socially responsible investors, and a goodly number of mutual funds, investment companies, state retirement boards, and investment advisors would utilize screening techniques to isolate companies having high degrees of social and moral responsibility.

Amy Domini notes, “The way you invest can contribute not only to your bottom line but also to a just and fair society.”[9] Yet, overwhelmingly, mutual funds do not utilize any qualitative SRI screening techniques. Perhaps the multiple qualitative criteria make the concept difficult to market? Karin Grablin, a financial planner with Dictor Martin Investments, has stated that “…most clients are pretty much looking for performance, and they’re probably more geared towards that angle than social responsibility.”[10] Investment management firms that manage client assets and/or manage mutual funds for investors have a responsibility to their investors to maximize returns. Without returns, such firms lose clients. Their choices are as much about their clients’ well-being as they are about self-preservation.

Why do the majority of firms seem apathetic towards SRI strategies? It has been strongly suggested that such strategies are simply less profitable than non-SRI strategies. Then the ethical question also becomes, “What is more important—social responsibility or overall profitability?” We know that the Adam Smith “invisible hand” (individuals collectively will undertake the best economic choice) is not always correct from a moral position. Is the return differential between SRI strategies and non-SRI strategies minimal, or does the alpha (or excess return not accounted for in its beta, a measurement of risk) of non-SRI investments compensate society for the negative societal externalities produced by corporations that do not act socially responsible?

Modern Portfolio Theory (MPT)

Two contradictory schools of thought exist about how to construct a portfolio of equities to maximize shareholder return. Modern Portfolio Theory (MPT) suggests that SRI investments are inferior to non-SRI investments. As per MPT, there are two categories of risk in the marketplace: systematic, associated with the overall markets, and unsystematic, or specific risk associated with a specific sector, industry, or business.

Diversification is the process by which investors add additional non-perfectly correlated securities in such a manner that Security A can partially mitigate the unsystematic risk of Security B within a portfolio. Efficient capital markets reward investors for systematic risk, which cannot be diversified away, but do not reward unsystematic risk, which is easily diversified away in an efficient portfolio through the addition of non-perfectly correlated securities.[11]

While all this sounds complex, it is not. Every stock and industry has a different business risk. MPT suggests that you take one stock from one industry (like an oil stock) and combine it with another stock with a different business risk profile (like a plastic manufacturer). The stocks move in less than perfect tandem (non-perfectly correlated.) In pragmatic terms, an investor should have no fewer than fifteen stocks in their portfolio with no more than two stocks from any one industry. This will result in a good degree of diversification being achieved.

Investors who choose to limit available securities using qualitative, non-financial criteria limit their ability to achieve adequate diversification. Using our example above, an investor might be forced to use three stocks instead of two from a particular industry. This portfolio like SRI funds will then bear a substantial amount of specific risk versus non-SRI funds and should logically achieve lower risk adjusted returns. In addition, firms that choose to invest capital in costly social programs increase costs and operate less efficiently than do firms that do not. Therefore, not only do SRI funds limit their investment universe at the expense of adequate diversification, but they may also be selecting from a pool of inferior companies that have uncompetitive cost structures.

Stakeholder Theory

Modern Portfolio Theory and simple portfolio construction accurately describe the diversification inefficiency that SRI strategies bear, but do not offer any explanation of possible benefits that socially responsible policies create. In support of SRI investments, the other school of thought is Stakeholder Theory. “Stakeholder Theory….portrays managers as individuals who pay simultaneous attention to legitimate interests of all appropriate stakeholders, both in the establishment of organizational structures and general policies and in case-by-case decision making.”[12]

In Modern Portfolio Theory, all stocks are considered homogenous. Stakeholder Theory suggests that a firm’s management of internal and external relationships will have significant positive or negative effects on future profitability. For example, a social agenda that includes above-market benefits for employees will attract the best workers, thereby making that company’s human capital more productive. Positive interactions with the communities surrounding plants/offices will result in more favorable negotiating power with local government officials for profitable tax breaks and other contractual obligations. Positive goodwill from superior social agendas will result in long-run economic and financial success. While the pool of possible investments is limited by using subjective criteria, Stakeholder Theory suggests that the available pool contains superior investments. As investors randomly select companies from a smaller pool of possibilities, the higher quality of those companies in the smaller sample offsets any negative effects described by MPT.

Eugene Ellmen, executive director of the Toronto-based Social Investment Organization (a non-profit trade association encouraging SRI strategies located at www.socialinvest.org) says: “Some people have the impression that to invest responsibly, you have to sacrifice returns…it’s a misconception to say that SRI investing leads to underperformance.”[13] Unfortunately, there have been many studies that have questioned this statement.

A recent paper by Michael Barnett and Robert Salomon has generated signal interest about SRI performance. Their very insightful paper also sought to distinguish between various SRI criteria, identifying the effects of the various SRI screens. Barnett and Salomon tested all 12 of the accepted screening methods (noted above) for SRI funds, but specifically targeted the effects of singling out firms due to environmental policies, labor policies, and community relations.[14]

The study resulted in several interesting conclusions. One such conclusion states, “The relationship between the intensity of social screening and financial performance for SRI funds is curvilinear or U shaped.”[15]

Mutual funds that use all 12 criteria are nearly as successful as funds that use none. However, mutual funds that use a handful of criteria, or that periodically relaxed their assumptions around social responsibility, suffer.

Mutual funds that stick to their core values and use all 12 of the accepted social responsibility screens apparently are able to realize on a broader scale enough long-term value through positive relationship building as to offset any negative results from lacking diversification.

Mutual funds that relax their criteria and show a lack of discipline towards those core values only end up bearing the negative externalities of less diversification; those companies do not realize sufficient positive value from their socially responsible criteria.

It would thus appear that SRI investing is an “all or none” proposition. This also mitigates the fact that particular SRI screens work at different times. In portfolio management, growth at times does better than value, or the reverse, and many other examples are possible.

Barnett and Salomon found a statistically significant—though small—positive relationship between positive community relations and financial performance. Michael Barnett reports, “Funds that select investments for their portfolio based on community relations screening criteria will earn higher financial returns than those that don’t.”[16] However, the study also showed that positive environmental track record and positive labor relations screening resulted in statistically significant negative effect on returns.

The Calvert Mutual Fund (CMF) organization is one of the better known SRI groups with a long-term record. It is useful to compare their performance against an SRI benchmark, albeit one they created themselves. The Calvert Social Index today contains approximately 600 large capitalized companies. The index is constructed by taking the top 1000 companies by capitalization and then analyzing each company according to SRI attributes. It is from this population that Calvert develops its portfolio selections. The performance of these funds is indicative of the gap differential in constructing SRI portfolios against the market. The performance results of selected funds are as follows for the period ended January 31, 2007 as reflected on the calvert.com website.

It is clearly disappointing that the Calvert Social Index (a non-managed fund) underperforms its noted benchmark (Lipper Multi-Cap. Core) in all three periods as well as underperforms the S&P 500 Index (total return) in the same three periods. Likewise, it is disappointing that the other two Calvert funds (managed funds selecting stocks within the index) underperformed as well.

SRI investment returns face a return challenge that must be clearly noted. Recognizing the limited testing period and population, socially responsible investing does appear to provide less than optimal investment performance. It appears that investors are not signally sacrificing their investment performance if they use very stringent social responsibility criteria. The fact that SRI mutual funds involved in the Barnett and Salomon study have higher expense ratios on average than do non-SRI investments[17] could account for the difference. Those higher expense ratios could be the result of lower operating efficiency of smaller firms that operate in the SRI marketplace rather than the difficulty of managing the portfolios. Regardless, the negative relationship is in no way significant enough to dismiss the societal benefit of the socially responsible stock selection. Rather, it raises the question of why more investors are not allocating funds to SRI investments.

One of the original questions in this article is whether or not social responsibility or investment returns has the greater value. For the individual investor, SRI investments utilizing currently existing SRI mutual funds will on average under-perform non-SRI mutual funds, encouraging investors to avoid them. However, since much of the underperformance appears to be a result of transaction costs and fund management expenses associated with small funds, there remains hope if more investors demand such types of SRI as part of their overall portfolio construction. This orientation could alter corporate decision making by increasing the demand for stocks of corporations having social priorities and policies deemed by society to be ethical.

According to Karl Marx, history is economics in action. If investors demand an SRI orientation, then it will follow. It becomes clearly essential that Value Based Investors insist on investing in Value Based Leadership Companies. This could promote positive initiatives for ethical conduct in workplace relations, production, and the environment.

This article also creates a challenge for pragmatic portfolio managers. The Calvert (or like) Social Index does contain a significant population. Are there not portfolio managing techniques available to construct within the social index a sub-set of companies that can not only outperform the index itself, but can outperform the Lipper benchmark as well? If so, there would be far less reticence by investors to own such SRI portfolios.